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Lecture 6. UNDERSTANDING EXCHANGE RATES (2). Exchange rates in the short run. The theory of the long-run behavior of exchange rates cannot explain the large changes of current (spot) exchange rates.

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Lecture 6 l.jpg
Lecture 6

UNDERSTANDING

EXCHANGE RATES (2)


Exchange rates in the short run l.jpg
Exchange rates in the short run

  • The theory of the long-run behavior of exchange rates cannot explain the large changes of current (spot) exchange rates.

  • In order to understand the short-run behavior, we have to recognize that the exchange rate reflects the price of domestic bank deposits (in €) denominated in terms of foreign bank deposits (in $).


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Comparing expected returns across nations

  • We consider Euroland the “home country”, and the domestic currency €.

  • The USA are the “foreign country” with the foreign currency $.

Euro deposits bearan interest rate i€.

Dollar deposits bearan interest rate i$.

How does Hans, the European, compare the return on dollar deposits abroadwith the return on domesticinvestments in € ?


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Comparing expected returns across nations

  • If Hans invests in the USA, he must realize that his return in terms of € is not i$. He must adjust the return for any expected appreciation/depreciation of the $ against the €.

  • If $-deposits bring an interest rate of i$ =5% p.a., and the dollar is expected to depreciate by 10% p.a. (w = $/€ ), the expected return in € is 5% - 10% = -5%.



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Comparing expected returns across nations

  • If Bill invests in Euroland, he must realize that his return in terms of $ is not i€. He must adjust the return for any expected appreciation/depreciation of the € against the $.

  • If €-deposits bring an interest rate of i€ =3% p.a., and the euro is expected to appreciate by 10% p.a. (w = $/€  ), then the expected return is 3% + 10% = 13%.



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The key point:

RET$ and RET€ are symmetrical (with opposite sign)

As the relative expected return on €-deposits increases, both domestic and foreign residentsrespond in the same way: they want to holdmore €-deposits and fewer deposits in $.


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Interest parity condition

  • At present, international capital markets are relatively open. There are few impediments to the flow of capital, and $ and € have similar liquidity and risk.

  • When capital is mobile and bank deposits are perfect substitutes, the expected return must become identical:


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Why? Arbitrage and liquidity trading

  • Whenever there emerge small differences between interest rates and/or changes of expectations on the exchange rate, there will be arbitrage in international money markets that evens out the differential between domestic and foreign returns denominated in one currency => Interest parity condition


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Market adjustment: Examples

We assume: i$ = 10%, and wet+1 = 1 $/€.

  • When wt = 1.0 $/€, the expected appreciation/ depreciation of the €  = 0% and the expected return in € is then equal to i$ = 10% (Point B).

  • When wt = 0.95 $/€, wet = 0.052 =5.2%, and the expected return in € = 4.8% (Point A).

  • When wt = 1.05 $/€, wet = -0.048 =-4.8%, and the expected return in € = 14.8% (Point C).


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E

D

Equilibrium in forex markets

wt ($/€)

RET$

RET€

1.05

C

1.00

B

0.95

A

14.8%

5.2%

10%

Expected return (€)


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What happens in disequilibrium

  • When w ≠ 1.0, there is a market reaction:

    • w > 1: People will try to sell € and buy $.=> “Selling €” and “buying $”

    • But no one holding $ will sell at that price, there is “excess supply” of euros;i.e. the price of €-deposits relative to $-deposits must fall.

    • The amount of dollars per euro falls, the euro depreciates.


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What happens in disequilibrium

  • When :

    • w < 1: People will try to sell $ and buy €.=> “Selling $” and “buying €”

    • But no one holding € will sell at that price, there is “excess supply” of dollars;i.e. the price of $-deposits relative to €-deposits must fall.

    • The amount of dollars per euro increases, the euro appreciates.


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Change in the foreign interest rate

  • If the foreign interest rate increases, the expected return RET$ also increases.

  • This leads to a depreciation of the euro.

  • The same is true if the expected return on dollar deposits increases (at the original equilibrium exchange rate).


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Equilibrium in forex markets

wt ($/€)

RET$

RET€

RET$

wB

B

C

wC

iD

Expected return (€)


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Change in the domestic interest rate

  • An increase in the domestic interest rate raises the expected return on euro deposits, shifts the RET€ schedule to the right.

  • It creates an excess demand for €-deposits at the original exchange rate, and this leads to an appreciation of the €.


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Equilibrium in forex markets

wt ($/€)

RET€

RET$

RET€

wC

C

wB

B

i€C

i€B

Expected return (€)


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What about inflation ?

  • If we assume that rational investors ask for a compensation for the erosion of a nominal value due to inflation, i.e. the “Fisher equation” holds, we have to be more specific

  • Expected inflation-rate differentials are embedded in nominal interest rates, and hence in the nominal exchange rate.

  • On top of the inflation-rate differential, the exchange rate reacts to differentials in the “real interest” rate.


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Factors that affect the exchange rate

Change invariable

Exchange rate change



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Share of financial innovations

Volume of forex transactions, in bill.$

Daily, month of April


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30

¥

20

3

£

11

2

$

Other

SFr

5

1

Other

25

2

2

Forex turnover by currency pairs (in per cent)



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Volume of trading by groups of actors

Bill. US dollars per day

With traders

With other financial institutions

With non-financial institutions

Actors in forex markets


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Citygroup

9,74

Deutsche Bank

9,08

Goldman Sachs

7,09

JP Morgan

5,22

Chase Manhattan Bank

4,69

Credit Suisse First Boston

4,10

UBS Warburg

3,55

State Street Bank & Trust

2,99

Bank of America

2,99

Morgan Stanley Dean Witter

2,87

The forex market is highly concentrated


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And will be concentrated even more …

  • Since September 2002 the forex market has changed: The CLS Bank started operating. It highly concentrates forex dealings due to a new technology.

  • On October 29th, the CLS Bank settled 15,200 transactions, totaling $395 billion, which required only $17 billion of payments between member banks, a 95% reduction.